Economics

Oil prices

Not that again

THE political situation with Iran has grown much more tense in recent weeks, and especially since the apparent assassination of an Iranian nuclear scientist. Some rich countries are now proposing tightened sanctions against Iran, and Iran continues to threaten to close the Strait of Hormuz, through which some 20% of world oil production passes. James Hamilton provides analysis of the potential impact:

The most likely outcome of an embargo on oil purchased from Iran is that the countries participating in the embargo buy less oil from Iran while other countries not participating in the embargo by more oil from Iran...While this would produce some dislocations, if total world oil production doesn't change, it would have little effect on either Iran or oil-consuming countries, and would basically be a symbolic gesture.

If instead the embargo is successful in reducing the total amount of oil sold by Iran, then the shortfall for global consumers would have to be met by some combination of increased production elsewhere and oil price increases sufficient to bring down global petroleum demand.

As for the first possibility, there appears to be only a limited amount of excess oil-producing capacity at the moment, and certainly far short of the 4.3 million barrels per day that Iran produced in the first three quarters of 2011.

Iran's production capacity represents about 5% of the world total. Mr Hamilton notes that supply disruptions of that magnitude in the past were associated with oil price increases of between 25% and 70%—and with American recessions. The American economy may have become slightly less sensitive to oil price shocks in recent years as consumers reduced their exposure after being burned by the spike in 2008. In general, demand for petroleum would seem to still be fairly price inelastic. And as Mr Hamilton notes, supply is very constrained in the short term. So one interesting thing to note is that Iran could potentially send America into recession all by itself, simply by halting its oil production for a few months. That wouldn't be good for the Iranian economy, of course, but perhaps that's a small price to pay for the smiting of one's enemies, and so forth. America couldn't easily respond with force as it would in response to, say, a nuclear attack. Closing the Strait of Hormuz would be a different geopolitical animal but would, if successful, bring the global economy to its knees.

According to a U.S. Energy Information Administration analysis, a $20 increase in the cost of a barrel of oil — roughly what we saw last year — is estimated to shave roughly 0.4 points off GDP growth in the first year alone and boost unemployment by 0.1 percentage points. So if Iran threatens to close the Strait of Hormuz (through which about 20 percent of the world's oil flows) and prices start screaming upward from $107 per barrel to $120 or beyond, that would put a very noticeable dent in growth.

What's more, oil shocks tend to have long-lingering effects. The EIA estimates that a $20 price increase continues biting into the economy for at last another year thereafter. James Hamilton, an economist at the University of California, San Diego, has suggested that the consequences of a price spike can persist for several quarters, as the resulting slowdown in consumer spending takes some time to ripple through the economy. That's true even if the spike is only temporary and recedes quickly.

Here's another way of looking at it: In 2011, the United States paid about $125 billion more for oil imports than it did in 2010 (thanks, in part, to the disruptions caused by civil war in Libya). That “oil tax” was essentially enough to wipe out the entire stimulative effects of Barack Obama's middle-class tax cut. A similar oil spike this year would cancel out a hefty chunk of the benefits of extending the $200 billion payroll tax cut bill that Congress is fighting over.

Dear oil has, in recent years, given a big boost to domestic fossil-fuel production in America, which is increasingly providing a meaningful if modest contribution to GDP and employment growth. Good as that is for the American economic outlook, there isn't remotely enough domestic supply to offset serious production losses elsewhere. To really insulate itself from these kinds of geopolitical hazards, America needs to dramatically improve its ability to substitute away from oil consumption. Progress is being made there, but not enough and not sufficiently quickly.

"Iran could potentially send America into recession all by itself, simply by halting its oil production for a few months."

Inflation was already sky high in Iran. Prices of food were doubling every couple months. The new financial restrictions will raise inflation further, perhaps into triple digit territory. There's reportedly a serious shortage of dollar in the country, as nervous Iranians withdraw their hard currency deposits from banks. The regime desperately needs the export revenue. A willful halt to oil production is highly unlikely. What concerns me more is the possibility that Iran's oil production facilities might start blowing up mysteriously.

I'm trying to remember the last time we weren't paying extra for oil because of instability in oil exporting nations. And I'm also kind of wondering whether the geopolitical instability premium is greater or less than the carbon price government would have set.

IT is quite another thing to hit international commercial ships and tankers from Europe, Central America, Africa, Australia and Asia. It will be a public relations disaster! Converting a focal Iran-American Conflict into Iran vs the West, the UN, World, and Globalization.

This will lead to immediate fuel shortages, huge lines, rioting and a shut down of the economy----IN IRAN.

Ironically while Iran is a Crude Oil Exporter, it lacks refineries for processing and cracking petroleum. Thus iran has to IMPORT gasoline, diesel, and kerosene. It is like being stranded on a raft on the ocean and dying of thirst. "Water, water everywhere and not a drop to drink." Crude oil cannot run machinery.

Iran depends on Gulf Shipping to bring in 90% of its fuel imports and exports; a Hormuz Embargo is cutting of their nose to spite the face.

Iran may be the first Arabian Government Revolution brought to bear principally by external conflict; which subsequently lead to internal dissent, market panic, economic shutdown protests and then revolution.

Compound this with the European, Japan, Korean, and potentially Chinese embargos. And major disruptions in alliances with Syria, Libya, and Turkey.

It is still winter, but Persian Spring is in the air. It smells like gasoline.

If we count the refinery gain as being two extra gallons per barrel (44 gallons out), $4.10 a gallon gasoline on $160 a barrel of oil would leave just a $.46 spread per gallon to cover all the assorted downstream costs involved AND the gasoline tax. That's so far into the red that it's a good thing that WTI only ever hit a monthly average price of $133 rather than $160.

The fact is, $3.60 a gallon on a barrel that costs $100 or more is par for the course and petroleum refining is hardly a hyper-profitable business for the majority of operators.

Ah, but an embargo on Iran combined with Drill Baby Drill here will accelerate us to the moment when the U.S. has zero unpumped oil and delay the moment when the Islamic Republic will be all tapped out.

At that point I suppose we will dig into the 30-some years of coal and nat-gas reserves we have left even more aggressively--aquifers and watersheds be damned.

Then, with a broken dollar and busted trade advantages (meaning, unable to afford a fraction of the imported energy that we get today), we will embrace energy self-sufficiency and renewables. I'm sure it will be quite a renaissance.

I keep an eye on the daily close of gasoline so I know when to tank up.

Last week the market price didn't budge much, but come Thursday it went from $3.30/gallon to $3.60 gallon.

Now, in order to prove your statement you have to supply a link to the futures market.
---
It's fearmongers like Mr. Hamilton that drove gold to near $2k.
I guess they want to unload a position in oil.
---
R.A.,

Remember when prices were down in the fall?
As I stated then, some of us didn't spend our "savings" because we knew they would find a way to drive up the price.

Remember Goldman Sachs' call last spring that oil was headed to $120/bbl? It tanked.

Global economy and oil...moving towards the Green Economy. Cut of the supply and sit back and enjoy the change. It will not be pretty but in the end well worth it! Whatever comes will be better than the current status quo.

hedgefundguy, in case you forgot, I work in oil/gas/energy consulting. Refining is a big part of our business. We know that at the refinery level, the price they get their feedstock at is determined not by the futures *market*, but by their own contract purchasing department. The price they charge depends on how well they hedge.

In the aggregate, however, I assure you that no one really knows what the gasoline price and oil price connection is, precisely because there is no good model of refinery behavior, output, and market fluctuations. And if *I* did, well, why would I be working instead of enjoying my youth on an island full of naked women, chocolate, and every episode of Star Trek on Bluray?

The real question that those in the oil industry will never want to answer is how many years of actual oil supplies we still have, as it is probably reasonable to assume that oil production peaked some years ago. The truth might well be rather too daunting for economic planners to swallow. The sooner we accept that oil will not be part of a successful long term economic perspective, and that we urgently need to start saving both energy and money, prevent applying for loans in UK and seeking renewable and sustainable alternatives, the more likely we are to collectively survive the massive energy crunch that will bring change resistant industrialised societies to their knees. Unfortunately, nature tends to the less energetic, and humans have always behaved according to that pattern.

During the '07 - '08 runup of oil prices to $147 (I guessed wrong at $160) the local paper asked the local president of the gasoline stations group to breakdown the costs.

He did a good job, saying you take the futures price and add $.xx for each of: transportation, state and fed fuel taxes, station profit, etc. That's what I use to decide whether to buy 5 gallons, or to fill up. The futures price + $.xx, but the futures price didn't jump $.30 when the pump price did recently.

Your explanation of what type of fuels - amount wise - are refined from each barrel does make sense for the futures price of gasoline.

(But I still stand by my assertion of fear-mongering and people wanting to unload a position.)

Bingo. The US/Israeli are trying to delay the nuclear problem long enough so that the EU and the US can introduce enough pain though hyperinflation to cause large-scale unrest & ultimately regime change in Iran.

One-by-one the US has closed off Iranian banking options although the Chinese aren't playing ball. They are largely indifferent to a nuclear Iran and desperately need the Iranian oil imports to meet demand.

Iranians won't shut off oil completely to punish the US/EU because the Chinese would suffer even more since more than 40% of their oil flows through the Straight of Hormuz & they get about 15% of their oil supply from Iran.